Orchid Island Capital Inc (ORC) 2014 Q3 法說會逐字稿

Good morning and welcome to the third-quarter 2014 earnings conference call for Orchid Island Capital. This call is being recorded today, October 28, 2014.

At this time the Company would like to remind the listeners that the statements made during today's conference call relating to the matters that are not historical factors are forward-looking statements subject to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Listeners are cautioned that such forward-looking statements are based on information currently available on the management's good faith, belief with respect for future events, and are subject to risks and uncertainties that could cause the actual performance or results to differ materially from those expressed in such forward-looking statements.

Important factors that could cause such differences are described in the Company's filings with the Securities and Exchange Commission including the Company's most recent annual report on Form 10-K. The Company assumes no obligation to update such forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking statements.

Now I'd like to turn the call conference over to the Company's Chairman and Chief Executive Officer, Mr. Robert Cauley. Sir, you may begin.

Thanks, operator. We are nearing the end of 2014 and the script the bond market was expected to follow is at the bottom of the garbage can, long ago thrown out with the junk mail.

The Fed has followed their script, tapering their Treasury and MBS asset purchases in a very well telegraphed moves and in nice even increments. The economy has followed its script growing at a very respectable rate although in uneven steps since the fourth quarter of 2013.

The housing market continues to improve albeit at a slower pace than in 2013. Payroll growth has averaged north of 200,000 jobs per month and has been accelerating recently.

So what went wrong with the bond market? Yields on US treasuries continue to rally briefly falling to 1.85% on October 15. Well, for one, Europe has not cooperated, teetering on the verge of recession.

Geopolitical events are too numerous to list but have dominated the headlines all year. We have an Ebola scare that is growing and unnerving the markets daily. So in spite of a very obedient Fed, an economy that has generally lived up to expectations, interest rates are not higher than yearend 2013 as was widely expected.

Instead they are closer to levels seen in the spring of 2013. In spite of all of this, the Fed funds futures market continues to price in the initial Fed rate hike from late 2015.

The agency RMBS market has had a good run all year as the current coupon 30-year Fannie Mae pass-through RMBS tightened to comparable duration treasuries and swaps all year until widening modestly with the rally-in rates on October 15. Even with that widening, mortgages are still significantly tighter than they were at the beginning of the year. Prepayment speeds have remained muted all year and as we head into the seasonal slowdown we do not expect a spike lower in rates earlier this month to cause much of an increase in speeds.

The events of earlier this month have caused volatility to spike higher, however, as the SRVX index, the CBOE interest rate vol index that measures the fair market value of future volatility implied by a 1-year by 10-year U.S. dollar swaptions, moved from 82 basis points to 90, but has since retreated slightly to 87.5 basis points. This index has been churning lower all year, however, and moving from over 96 basis points on December 31, 2013, to a low, a near 76 basis points at June 30.

The funding markets for agency RMBS remain open and funding levels are in the low 30 basis point range for one-month terms, slightly lower than at the beginning of the year. The market still anticipates potential shrinkage in lending capacity for RMBS once the new bank liquidity and leverage ratio restrictions necessitated by Dodd-Frank and Basel III are implemented but the timing of this remains very uncertain.

Orchid has enjoyed a very successful year in all regards. We have grown our equity base throughout the year completing two secondary offerings in the first quarter and implementing an ATM, or at-the-market program, in late June. We exhausted the $35 million capacity of the first ATM program in early September and started on a second $75 million ATM program the next day.

The Company commenced the first ATM offering on June 17, 2014, and the second ATM offering on September 3, 2014. Through today the Company has sold 3,979,472 shares through the two ATM programs raising approximately $54 million in proceeds net of fees paid to the agents.

The weighted average sales price of these shares was $13.87. The Company's book value per share was $13.05 at June 30, 2014, and $13.27 at September 30, 2014. At September 30, 2014, our shareholders equity was $172.8 million, up from $44.8 million at December 31, 2013.

And finally, we have changed our listing from the NYSE MKT to the NYSE and started trading on the NYSE on October 8, 2014. As a result of the deployment of the new capital, the RMBS portfolio grew by approximately 34% during the quarter and has grown by almost 235% year to date. We continue to shift the exposure towards fixed-rate RMBS and 30-year securities in particular.

We have also been increasing the weighted average coupon of the pass-through portfolio from 3.70% at September 31, 2013, to 4.14% at June 30, 2014, and 4.26% at September 30, 2014. The capital allocation was shifted slightly from 59.9% pass-throughs and 40.1% structured securities at June 30, 2014, to 61.0 pass-throughs and 39.0% structured securities at September 30, 2014. To compensate for the added duration of the 30-year securities, we continue to add to our funding hedge positions by increasing our Eurodollar shorts and adding 1- by 10-year payer swaptions to the 1- by 5-year payer swaptions already in place.

The notional balance of our hedges in place at September 30, 2014, represented approximately 76% of our repurchase agreement balance based on our anticipated repurchase agreement balance once all unsettled security sales and purchases are settled. With the structured securities portfolio we added one IO and one inverse IO security during the third quarter. The IO security was collateralized by 20-year, 3% fixed-rate collateral; the inverse IO added is collateralized by a moderately seasoned 30-year 4.5% fixed-rate collateral.

During the third quarter both IOs and inverse IOs continued to perform well in spite of lower rates and a flatter treasury curve. The benefit of slower prepayment speeds in the market its apparent conviction that speeds are not likely to increase anytime soon for other reasons.

The performance of our structured securities was net positive for the quarter. Our IO securities are still negative yield assets but the inverse IO positions generated positive interest income. Positive mark-to-market adjustments on both our IOs and inverse IOs offset by slightly negative interest income resulted in a 2.7% unannualized return on structured securities portfolio for the quarter.

As has been the case we continue to own these securities for their upgrade protection and generally do not look to them as significant income producing assets. As I stated last quarter, we continue to long for the days when the current rate refreshing environment ends and these assets can be used in conjunction with a levered pass-through portfolio such that the income and price appreciation potential are more balanced.

As reported, our leverage ratio was approximately 7.3 to 1 at September 30, 2014 which does not reflect the $66.8 million of unsettled security purchases which are not financed prior to settlement. However, when adjusted to reflect $246.8 million of unsettled security sales, the repayment of the $238.5 million in related repurchase agreement obligations and the $66.8 million of unsettled security purchases which will be secured by new repurchase agreement obligations our leverage ratio would have been approximately 6.3 to 1 at September 30, 2014.

In other words, adjusting for unsettled purchasing sales are leverage ratio is one turn lower. The portfolio is positioned for a continuation of modest prepayment speeds and we expect the Fed to start to raise the rates next year. The incoming data will determine whether that occurs at midyear, as was expected just a few weeks ago, or later in the year as is currently expected.

As I have mentioned previously, mortgage borrowers have been exposed to very low rates for extended period and show a reduced sensitivity to refinancing opportunities. Mortgage lenders have reduced their capacity and new regulations imposed by the Dodd-Frank Act have impaired their ability to quickly ramp up their staff or capacity levels further muting refinancing activity.

We still see the greatest risks to the market as twofold. The first would be an outbreak of inflation resulting in a more aggressive Fed and elevated volatility in the rates market. The second would be a continuation of the rally we experienced early this month.

To address the first risk we have added to our swaption position, especially on the 10-year part of the curve. The inflation scare will likely impact the long end of the curve and we would expect volatility to move meaningfully higher as the market priced in more substantial Fed tightening.

In this scenario we anticipate these hedges will perform very well. We continue to guard against a further rally by maintaining a material allocation to call protected securities. We shifted from the highest quality, high premium call protected securities, loan balance and credit impaired bonds, such as HARP bonds, to more fully fairly priced securities that still offer call protection but with better carry per unit of duration.

We did not anticipate a meaningful increase in speeds even if the market rallies further for the reasons mentioned above. But our portfolio of exposure to high coupon fixed-rate securities requires adequate protection from excessive speeds if we are wrong. We believe these securities will provide adequate protection in the event of a rally and the premiums we paid will likely have room to increase to offset the premium amortization that would occur.

That concludes my prepared remarks. Operator, we can turn it over to questions.

(Operator Instructions) Steve DeLaney, JMP Securities.

Thank you. Good morning, Bob, and congratulations on the growth in the Company this year and on the recent NYSE listing.

I wanted to just ask your mix as you and Hunter run the portfolio I think you are showing here that in terms of capital allocation, which is I think a great way to talk about it rather than asset mix, 61% pass-through, 39% IO. Can you remind me what the range has been if we look back over the last year?

What has sort of been the range there in terms of the IO percentage and how large could you allow that IO allocation to go given whole pull requirements? If we were to see or expect a more aggressive Fed and slower prepays and you might want to overweight the IO a little bit more, what is your flexibility I guess is what I am really asking there?

Sure. We are actually at or near the low end of the range in terms of our allocation to IOs. Obviously we've only been public since February 2013 but we've been running this portfolio actually for close to six years now. It has actually been as high, almost 70% IOs at one point and the interesting point, though, is that we don't apply leverage to the IO securities and we do apply leverage to the pass-throughs, you have the latitude to take the IO capital allocation quite high.

Just because for instance if you had $100 million in capital, if you had say $65 million in IOs, that other $35 million capital could be levered 7 or 8 times. And you easily get over the 55% whole pull threshold. Hunter, do you want to add to that anything?

Yes, since the IOs are priced on a notional balance, the fair market value is quite a bit lower and that is the key metric for the test. So if we have a IO that is backed by $100 million notional balance it might have a $15 million value whereas a $100 million worth of pass-throughs is going to be worth something north of $100 million in our premium portfolio.

Great. And just a follow-up.

Just looking within the structured product, it looks like the mix between IO and inverse IO was sort of 70% IO as of September 30, and obviously the return, the unlevered return, is better I think I heard you say on your inverse IOs currently. Again if we were expecting more action, if you will, on the short end in the next 6 months to 12 months, would you then shift more to find the IO product more attractive relative to the inverse IO?

I would say so. Generally the IOs have actually improved. It wasn't that long ago that they were almost all maturely negative yielding assets.

Now we can find some that are positive yield. And as you say the inverse IOs because of their exposure to the Fed, unless you can get very very short cash flows it is hard to get away from that. So we have been trending more towards IOs versus inverse IOs.

We do focus, Steve, on inverse IOs that are relatively short cash flows. We like to keep the dollar prices fairly low just in that sort of -- you think in terms of a cash flow multiple, we like to see kind of low multiple inverse IOs off of collateral that is paying relatively fast so that if the market for whatever reason will wake up tomorrow and the expectation is that the Fed is behind the curve, we expect we would see some sort of a long end sell off in a magnitude greater than what we would experience on the front end.

So in that scenario we would get a lot of cash flow extension by virtue of the fact that the prepay speeds on those pools underlying the inverse IO would extend pretty dramatically. So we look for -- said another way, we look for low duration inverse IOs.

Right, right. Okay, guys. Well, appreciate the color and good quarter. Thanks.

David Walrod, Ladenburg.

Good morning, guys. I just wanted to ask a couple of questions to elaborate a little bit.

I know you had a little discussion with pre-pays in your prepared remarks and you also discussed a little bit of a change to the assets you were buying. Your pre-pays picked up, I know you said you still think they are manageable but they did pick up a little bit. Can you discuss your outlook for pre-pays and also maybe give a little more color on types of assets you are buying now as opposed to what you were buying previously?

I'll take the first part and Hunter can take the second. We think there will probably be a very modest reaction in terms of speeds to the spike lower in rates this month but I don't expect it to last. It won't persist.

And after that we get into the seasonal slowdown, so our expectation is for things to remain quite muted. That is where we take our risk, if you will. Our portfolio is exposed to a rally and a significant increase in speeds and we are comfortable taking that risk.

As far as the mix of assets, I alluded to it briefly. We have shied away a little bit from the highest quality call protected securities. And I will let Hunter talk a little bit about what we have been buying.

So one of the strategies we like to employ as we bounce around the range that we have been in and we sort of broke out of it a little bit to the low side over the last month or so, but when we saw that taking place one of the things we started to do was sell some of the weaker story assets in the portfolio. So as you know, we have a relatively high premium portfolio; we put that in place because we feel confident that prepayment speeds are not going to trend materially higher for a long period of time.

And so when we have moments of time where we retest lows or get to recent lows, a lot of times we will take advantage of that period by selling some of the older, more seasoned, less effective stories and replacing them with not necessarily more expensive stories but new versions of the things that we like. So zero [walwa], low FICO, high LTV.

We get those in say September, October, November production, we think we've got a pretty good shot of making it through whatever spike occurs in the next couple of months related to testing those lows and rates. And then hopefully we are on our way to well into the seasonal slowdown in speeds after that initial pop, or whatever you want to call it. But by and large it has been, as I say, more or less the same types of collateral just newer versions of it.

Okay. And obviously you guys have been growing a lot; you grew out in the quarter. I just want to talk a little bit about your hedging strategy.

It looks like you didn't really add to the Eurodollar future portfolio but you did at a swap. Can you talk about -- I guess you added a swaption. Are swaptions, you think, a more effective way to hedge, and I guess at what level of hedging do you want -- do you feel comfortable being at?

We did increase the Eurodollars since quarter end slightly. I think I mentioned we are about 76%.

We actually added a little bit more to that in anticipation of potential growth. And swaptions are very effective tools just because you have two elements in them.

Obviously you have the option element, so you have exposure to vol and then you can pick your point on the curve for the swap. Swaps have become a little more difficult to use because of the capital requirement.

There's initial margins. I'll let Hunter add to that.

Yes, the one thing I would add is that throughout the course of the year there has been some great opportunities to add products which are dependent upon volatility such as swaptions. And we sort of bounce back and forth between the two different products, or between -- the types of things that have optionality and those that don't based on entry points and what we need in terms of our convexity concerns.

As I alluded to earlier, we think that swaptions are a great product for that inflation fear type of scenario that Bob outlined in his prepared remarks. Because any type of spike higher on the long end of the curve would be very detrimental to companies like ours. And we think the only way that can happen is with a spike in volatility as well.

Those unintended benefit of those transactions was in the rally we saw that we witnessed in mid-October we saw a nice spike in volatility which offset some of the mortgage widening that we also were witnessing during that period of time. So just kind of taking a step back, though, from a high-level perspective our portfolio has behaved in a very flat manner.

So as rates have bounced around we have actually even witnessed periods of where our empirical duration has been a little bit negative. We think on a -- as we break out of a range in some kind of a panic selloff type of environment, that's not likely to be the case. So that's why we have focused on some of the option trades.

Just one point I want to add to that, Dave, is that we talk about this inflation outbreak and what would happen. We don't do that as a high probability event.

It is probably quite low but it would have very material negative benefit to us and that is why we guard against it. And one final point, when we had the spike in rates down on October 15, after that dust started to settle, we kind of took advantage of that. And that's when we did some of the hedge trades, take advantage of the lower forward curve at the time.

Okay, great. And then just to summarize it, 76%, that's kind of the ballpark of where you would like to be on a hedge basis?

With those products. Keep in mind we have negative duration in the structured mortgage book as well. So we are more fully hedged then 76% when you take into account the negative duration in the IO and inverse IO portion of the portfolio.

And also the IOs, your exposure there is more to the long end in terms of as a hedge where as the Eurodollars are more in the belly. So hedge the belly risk through Eurodollars, hedge the long end risk through a combination of swaptions and IO.

Okay, great. Appreciate the color. Thanks, guys.

(Operator Instructions) Michael Diana, Maxim Group.

Hi. I think I heard you say when your receivables and payables for securities all settle your leverage is about 6.3 times. Is that where you are comfortable with in this environment?

Yes, we have been running between 6 and 6.5 for quite a while now and that's right in the middle of that range.

Okay, great. Thanks.

And at this time I am showing there are no further questions in the queue. I would like to turn the call back over to management for any closing remarks.

Thank you, operator. I appreciate everybody's time today.

To the extent anybody has any follow-on questions, something that comes up after reading the Q or something, please do not hesitate to call. We will be in the office all week and we look forward to talking to you next time.

Ladies and gentlemen, thank you for your participation on today's conference. This concludes the program.

You may now disconnect. Everyone have a great day.